WeWork, which become the most active serviced office provider in Europe in terms of take-up, will have to adjust to a new environment with their ego heavily deflated, UBS says, along with renewed scrutiny on the business models’ mismatch between long and short-term lease liabilities.
Zachary Gauge, European real estate analyst, at UBS-AM Real Estate and Private Markets, explains:
“The liability mismatch is a risk from the operational side, and whether this type of business is sustainable remains to be seen, but the attraction to the corporate occupier is clear and it has raised the bar for what is expected from traditional landlords.
“The end result of this for the investor is ultimately higher capex and management requirements in return for shorter terms of guaranteed income, leading to lower overall returns from the asset class over the longer term. This is not necessarily an issue as many investors now accept that we are operating in a lower growth, lower return environment, but it is particularly important that sensible assumptions on future capex, vacancy and re-leasing costs are factored into the cash flows at the acquisition stage to avoid unpleasant surprises further down the line.”
Despite UBS’ concerns over the business model employed by serviced office providers, the fund manager expects the sector to remain a significant part of European occupational markets for the foreseeable future. The challenge is trying to understand where the equilibrium rate of penetration is, and acknowledge that individual markets will have different levels based on some of the factors outlined earlier, says UBS.
Zachary Gauge added:
“In reality, we will probably only find out the true equilibrium levels once the European market has entered a significant downturn on the occupational side, which would stress test the business models of the operators. It is difficult to predict exactly how this would play out, as much would depend on the severity and length of the downturn itself.
“We would expect that the providers that survive the downturn are the largest, with the strongest capitalisation, lowest levels of leverage and the lower average rental costs across their portfolio. We would also expect to see a fair amount of consolidation within the sector as it becomes more mature and providers focus towards the corporate leasing side, which requires greater scale. And this is where we see the longer-term challenges for traditional landlords really developing.
“Taking aside any weakness in the individual covenant strength of the providers, there is a clear systemic risk of having a serviced provider as a tenant. The issue is that the serviced providers’ model is ultimately driven by the same as the landlords’ office investment portfolio; ie. occupational demand. So, in a downturn scenario, while traditional occupiers’ businesses might suffer, the attributed risk would be nowhere near as intrinsic as the serviced office providers’ and the landlords’.